Friday, June 23, 2017

The "bucketing" problem in financial markets

In recent weeks rating agencies have come for stinging rebukes from India to China and Russia. Livemint has this story examining whether rating agencies are biased against India and developing countries.

In this context, I had blogged earlier pointing to this article by Nandini Vijayaraghavan which gets to the heart of the problem with any ratings approach - it buckets the target populations, and does ratings based on assessments across and within buckets,

The impediment to the rating agencies upgrading India’s sovereign ratings lies in their methodologies. The sovereign rating methodology factors economic strength, institutional strength, fiscal performance, and susceptibility to event risk to assign ratings. The rating agencies categorise countries into buckets based on their size (GDP), growth, volatility of growth and per capita income, among other factors. The emphasis on per capita income is because countries with higher per capita incomes are better equipped to withstand cyclical volatility and are endowed with higher debt servicing ability. India’s low per capita income has resulted in its sovereign rating being lower than countries with higher deficits and indebtedness and lower growth prospects.

For example, in India till recently, rating agencies would not let even highly prudent, historically well managed, and resource rich sub-state entities, like say a state distribution company or a municipality, pierce the ratings accorded to their respective state governments. This deterred the best run and most credit-worthy urban local bodies and distribution utilities from accessing bond markets, with their higher cost of capital (due to the lower forced ratings), and preferred banks instead. This bears at least some part of the blame for the still-born municipal bond markets in India.

But rating agencies are not the only financial market agents to use the bucketing approach. Such bucketing produces distortions all round financial markets with profound impacts. Consider the interest surrounding MSCI's decision to include mainland Chinese equities, known as A-shares, in its benchmark emerging market equity index. This means that the $1.6 trillions of global funds that track the index will now have to buy into mainland Chinese stock market.

Incidentally, despite mainland China being the second biggest global equity market, MSCI has limited the exposure of A-shares to just 0.73% of the index. It has clarified that any increase in weight will be dependent on corporate governance reforms in the mainland's equity markets, which had been subjected to very heavy regulatory intervention last year in response to downward volatility. However, this small percentage is deceptive since the actual exposure of the index to Chinese companies, through those like Alibaba and Tencent floated elsewhere, is 25.3%.

The MSCI is only the largest and most high-profile of indices that bucket emerging markets and force the bundling of these countries as asset categories. This is no small contributor to the observation that cross-border capital flows does not discriminate among emerging market economies and treat them all as a single asset class. Accordingly, even countries with strong economic fundamentals cannot escape the tyranny of asset buckets when sudden stops leads to capital flow reversals.

In the context of the MSCI decision and the intense lobbying surrounding it, John Authers writes about the large power wielded by such indices,

Indices are not impartial or abstract constructs; they are an expression of someone’s opinion, and this should not be forgotten. And perhaps most importantly, there is something ungainly in the way such power has been outsourced to MSCI, a relatively small for-profit organisation based in New York. Such a momentous matter as the terms of trade in which capital flows between China and the rest of the world might seem more naturally to belong to democratic or governmental institutions. Either that, or this should be an issue for the market to decide, without intervention by governments, or heavy guidance from MSCI. As it is, the big multilateral organisations do not seem to be providing the leadership provided... something is not right with the way capital markets have come to operate when a small company like MSCI can tell the world’s most populous country what to do.

Indices, like rating agencies, distort the global equity markets in different ways. These distortions are best captured by the rise of passive exchange traded funds (ETFs), which form an increasingly large share of all equity assets. ETFs, which were introduced 25 years back, now track more than $3 trillion worth assets and are dominant share of the market in countries like Japan.

For a start, such index tracking funds contribute to a Mathew Effect, making larger company scrips which are likely to be part of many indices, rise even more. Authers explains with the example of Amazon,

But how much of the positive performance for Amazon is down to the momentum created for it by indexers? As investors switch to passive, or to the numerous different factor funds which currently hold a lot of Amazon, so the stock appreciates. The problem is that most stocks, including Amazon, are now judged as a series of factors with a series of properties, rather than as companies. Mark Lapolla of Sixth Man Research expressed this well, saying that the initial reaction to the Amazon purchase was not to be trusted and that

“there is a higher order context in play that is a critical point of understanding for fund managers. Namely, it is taking place at a time when passive and quantitative investors account for 60 per cent of equity assets under management and are estimated to drive about 90 per cent of daily trading volumes.”

On this basis, he says that Amazon

“is no longer a dynamic business, but a complex, inconstant security ‘type’ that proliferates data points used to predict the direction of its stock. In this new paradigm, cost basis and expected return have no meaning; the direction of price is all that matters.”

Finally, after looking through the latest holdings statements, he makes the devastating point that of late Amazon has been sold by the biggest active investors, whose stakes have ended up with big passive players:

— It will take some time for this acquisition to prove out and, in the meantime, unless the positive, fundamental buzz turns negative, AMZN will continue trading as quantitative “type” and not a business.

— A final note of interest: As of the Q1 13Fs, the largest, active investors have been selling their Amazon holdings to passive investors, quants, and the national banks of Norway and Switzerland.

More generally, index tracking funds, as Authers writes elsewhere, contribute to the inflation of bubbles and amplification of market volatility,

According to George Cooper, a fund manager and author of The Origin of Financial Crises, “the big beef” involved in tracking an index is that “you mech­anically lend most to the biggest borrowers, and buy the most overinflated stocks”. He draws an analogy with road safety: “Imagine a motorway where cars all benchmark their speed to everyone else. Then imagine what happens if everyone is trying to be a little faster than everyone else. They end up crashing.”

Paul Woolley, head of the London School of Economics’ Centre for the Study of Capital Market Dysfunctionality, suggests that market benchmarks inflate bubbles and should be abandoned altogether, in favour of comparing fund managers to rises or falls in gross domestic product... Most bond indices are weighted according to how much debt a company or country has issued. This means that the more indebted an issuer becomes, the bigger share it will take in the index, and the more of its debt passive funds will be required to buy. This is why many funds were led to load up on Argentine debt before its default crisis...

But there are also concerns about the use of indexing in equities. Most indices are weighted according to market capitalisation. That means the more a company’s price grows, the more index-trackers will be required to buy of it, open­ing them up to accusations that they help to inflate bubbles. A second charge is that indexing at­tacks market efficiency. The more money passively tracking indices, the less devoted to seeking out underpriced stocks. If all money were managed passively, markets would cease to function.

In fact, it gets even worse,

Not only are the indexers powerful, but that power is concentrated in a few hands. Consolidation has left three big companies — S&P Dow Jones, FTSE Russell and MSCI — jointly providing the benchmarks for 73 per cent of US mut­ual fund assets, worth some $9.4tn. In bonds, the indices overseen by Barclays are dominant. Its bond aggregates (formerly known as the Lehman Aggregates) account for more than half of all ETF assets held in fixed income.

At one level, bucketing is a lazy approach to assessing and pricing risk. Instead of developing country-specific metrics and surveillance systems to keep track of them, rating agencies and indices initially preferred to take the easy way out by bucketing and reducing the monitoring data points. But once established, vested interests and market inertia have taken over and now come in the way of any change.

In the context of rating agencies, there is some evidence that Credit Default Swaps may be a better measures of credit-worthiness of the entity. Yang Liu and Bruce Morely used panel data from the main EU countries, US and Japan and found,

The results indicate there is little evidence to show any relationship between the credit ratings and the sovereign CDS spreads,and the main drivers of sovereign CDS spreads are macroeconomic fundamentals which reflect the ‘health’ of the economy.